Economics

China's cash crunch

China's Volcker shock

IF YOU fix the price of something, the quantity demanded may vary a lot. If instead you fix the thing's quantity, then prices will jump around. Most central banks now peg the interest rate at which banks can borrow reserves. This price therefore remains pretty stable. And when central banks feel the need to raise it, they do so in deliberate, incremental steps. We're used to charts like the one opposite which shows two overnight, euro-area interest rates in 2006, the year before central banks lost control.

But when the price of borrowing is fixed, the amount borrowed can vary a lot. That is evident in the second chart, which shows the amount European banks borrowed from the ECB in the same year.

In China, as everyone is discovering this week, things are different. The country's central bank, the People's Bank of China (PBOC), sets a target for the quantity of money (M2) and uses quantitative reserve requirements to keep money and credit in check. It does also fix some interest rates: it caps the rate banks can pay their depositors, and it puts a (largely redundant) floor under the rate they can charge borrowers. But it allows the price at which banks borrow from each other to flap around much more than other central banks would tolerate. The seven-day repo rate, which has become a key benchmark, has risen from just 2.78% in mid-May to over 10% on Thursday (see third chart). And although this cash crunch is unusually severe and prolonged, it is not unprecedented. In January and June 2011, interbank rates also spiked after the central bank unexpectedly raised reserve requirements. In their volatility, Chinese borrowing rates resemble euro-area borrowing quantities much more than they resemble comparable rates.

Many commentators on this month's cash crunch in China have compared it to America's 2008 crisis, when the rate at which banks said they would lend to each other shot up, far in excess of the Federal Reserve's policy rate. But that spike reflected a different original cause. It was not so much that the demand to borrow shot up, it was more that the perceived quality of borrowers declined. The spike reflected the increased risk of insolvency more than an increased demand for liquidity, although of course both factors were at play.

A more interesting analogy, offered by Peter Thal Larsen of Reuters Breakingviews, is with the Bank of England's hesitation in August 2007. Committed to the macroeconomic goal of price stability and the microeconomic virtue of market discipline, the BoE briefly neglected its financial duties as lender of last resort. It was so determined not to give reckless bankers what they wanted, it almost failed to give the banking system what it needed. In this analogy, the thoughtful, owlish Zhou Xiaochuan is presumably playing the part of the thoughtful, owlish Mervyn King.

But a third analogy is perhaps also worth making. The West's central banks have not always targeted interest rates. After Paul Volcker took charge of the Federal Reserve in 1979, it stopped trying to target a price--the federal funds rate--and began to focus instead on a quantity--the amount of (non-borrowed) bank reserves. Small, incremental increases in the policy rate had failed to impress the markets or arrest high inflation. That tactic had "run out of psychological gas," Mr Volcker argued. So he seized on something less compromising. The Fed set targets for the growth of the money supply, much as China's central bank does today. And it let the federal funds rate go where it may. As a consequence, the funds rate went a little Chinese (see final chart).

Historians debate whether the Fed really believed in monetary targeting, or whether the new theory merely gave it a convenient excuse to raise interest rates as high as they needed to go. Perhaps China's cash crunch is also an attempt at a second-best solution to a stubborn problem. Denying banks access to cash is an awful way to punish them for excessive lending. The liability side of the banking system is a horribly risky terrain on which to wage such a fight. But Mr Zhou may feel he has no choice. China's authorities have more control over the liabilities of China's banking system than they appear to exert over its assets. They have failed to stop banks making excessive loans, because banks have found ways around prudential lending limits. In particular, they have disguised long-term loans as short-term interbank assets.

But when the banks then come begging for the funding they need to support their hidden balance sheets, they are once again at Mr Zhou's mercy. And so far, he has shown little.